The pros and cons of the freemium business model

Is the ‘freemium’ model really a new, sustainable way of doing business?

by James Hurley

Updated: Sep 4, 2013 Published: Oct 14, 2009

Is the ‘freemium’ model really a new, sustainable way of doing business or merely a short term marketing ploy that will always need to be monetised in relatively conventional ways? GB ponders the future of free.

The traditional measure of economic success, profit, doesn’t sit well with numerous web companies. Few would question the value of micro-blogging site Twitter, which took just two years to reach one million users on the back of $5m of initial funding. Remarkably, for all its global reach, it also has just 50 employees as of year three. It’s still waiting to become profitable, however, and no one is quite sure how to monetise it. With open access and no adverts, in its current incarnation, it arguably looks more like an impressive but unsustainable free service than a viable business.

Twitter is reportedly now planning for the inclusion of advertising, but if the recent history of the web is anything to go by, that’s hardly an inspired solution. The relative failure of the first wave of web businesses to convert the millions of “eyeballs” they generated into advertising revenue did not deter the giants of web 2.0; once Google could help businesses properly target internet advertising and there were enough consumers with high speed broadband connections, it was thought that monetising the web would be more straightforward. Yet the wisdom of giving products away for free to the end-user remains questionable.

Site visitors generally expect the content they engage with to be free but the number of companies which have established a sustainable business model based purely on open access and internet advertising is much smaller than the second wave of web entrepreneurs had hoped. Once again, internet firms are scaling back, hoping for a trade sale or, most pointedly, talking about charging for their content. While online advertising revenue undoubtedly has its place, the impact of the downturn has made it clear that advertisers alone won’t be able to indefinitely fund the free-for-all.

Charging a freemium

The latest saviour of the web is the ‘freemium’ model: offering basic services for free, while charging a premium for advanced or special features. Regular web users can be attracted by free services which are paid for by a significant minority of users enthusiastic enough to upgrade to premium ‘added extras’. Skype, LinkedIn, Flickr and dating site Match.com all employ the model, while Facebook is also considering it according to Yuri Milner, the CEO of DST, one of the social network’s investors. It’s also become the favoured monetisation method for fledgling web start-ups.

In Free: The Future of a Radical Price, Chris Anderson, Wired US editor, argues that an average of just 5% of users need to pay for a premium version of a site to make it viable. On that basis, the attraction for web entrepreneurs – who are rightly concerned that the vast majority of users expect their interaction with the web to be free – is clear. The few can pay for the many since the cost of supporting a free user, Anderson writes, is now “too cheap to meter” thanks to the ever decreasing cost of technology.

The founders of VC-backed digital music service Spotify, another standard bearer of the freemium model, may beg to differ. Established by Swedish entrepreneurs Daniel Ek and Martin Lorentzon in 2006, the streaming site has impressive agreements with labels which give its 2.5 million UK users access to some 4.8 million tracks. The service is not short of evangelists but despite a revenue model that blends an advertising-supported free service with an ad-free premium one, including a £9.99 subscription-based mobile phone application, the same can’t necessarily be said for its revenues. While its monthly costs for bandwidth and streaming songs under licence from record labels are now thought to be close to $6.5m – so much for “too cheap to meter” – advertising revenues in July were reportedly less than £100,000. Upgrading users to premium accounts is also proving tricky; as few as 10,000 UK users are paying subscribers.

Yet Ek remains a proponent of the freemium concept. “With a freemium model, we have always realised that the vast majority of our users are, and will be, free users. That’s been alright with us because as long as the scale is big, the numbers work,” he says. Indeed, if Spotify can improve its free-to-paid conversion rate, the model may yet prove profitable. A Sunday Times article estimated that the firm can break even without advertising revenue if around 10% of users switch to a subscription, or just 7% with advertising income, numbers which it’s close to reaching in a number of its territories.

Ek won’t disclose the percentage of paid subscribers Spotify has, but confirms that “it’s not a double digit percentage. We think we can get there, but we’re not there yet”. Even if Spotify can prove the model on this basis, it’s clearly going to be a tough slog, and for some, ‘free’ is to be utilised in the short term for raising brand awareness and traffic rather than as the new way of doing business it’s been hyped as.

From free to paid

In Anderson’s view, content owners and distributors have their heads buried in the sand and, like death, free is an inevitable absolute that can be temporarily denied but not avoided. “In the digital realm you can try to keep Free at bay,” Anderson writes, “but eventually the force of economic gravity will win.” In his view, the digital age is enforcing an irreversible downward pressure on the prices of all things “made of ideas” – clearly, bad news for content owners. Jon Davie, managing director of digital content agency Zone, disagrees: “All that’s happened is that where value is on the distribution chain has moved. In a world where distribution is ubiquitous you can’t make money from just owning distribution. That’s not to say there’s no value anywhere in the distribution chain.”

Davie says disruptive technology is “driving value to different, sometimes unexpected places”. In the music industry, for example, value has shifted from selling recordings to gigs, merchandise and licensing. Freemium can form part of the answer – a band might give away an album in order to promote live shows, for example – but the tough job of converting users from free to paid will mean employing some old school disciplines. “The absolute key to it all is having unique, valuable content. You’ve got to have something that people can’t get elsewhere,” says Davie. Introducing payment, he says, “has got a lot to do with traditional marketing, merchandising and packaging skills”.

Patrick Mork, vice president of marketing for mobile application distributor Getjar, says the fact that the applications his firm offers are free has delivered market share and loyalty, the basis from which it will be able to charge for applications in future. “What we see, and the reason Getjar has been free so far (we plan to offer monetisation in the future) is that we believe that to get the mass market excited about content, you need to generate trial. The best way to do that is to give away products so they can be used in a risk free way.”

Getjar already makes revenues from its ‘PPD’ (pay-per-download) model, which is analogous to Google’s Adwords PPC network in that it allows app developers to bid for premium visibility on the site. Mork concedes that for the developers themselves, monetisation can be tricky. “It’s not easy to make money from applications if you can’t charge on a download basis,” he says. The most obvious way to do so is through advertising, although this will rarely offer a significant, sustainable income on its own and may compromise the user experience – a similar story to online.

Murdoch’s map

So how can businesses best add freemium to the revenue mix? “You have to walk a fine line. You need an offering which is basic and clearly lacking some important bells and whistles,” says Mork. “It will vary from business to business, but the right time to start charging is when you’ve got a critical mass of loyal users who are extremely satisfied and the basic, compelling reason they came to you hasn’t changed and you’re not charging them for something they’re already doing. You need to be giving them something new,” he says.

And, crucially, the payment system has to be as simple as possible; instead of a traditional subscription, most believe a micropayment system similar to the one employed so effectively by Apple’s iTunes and App Store will eventually be adopted by ecommerce businesses of all descriptions. Mork says a basic service that’s free, combined with premium content that can be paid for at the touch of a button and charged at a low price that’s accessible to most people “will help businesses like ours make the transition from free to paid”.

For the publishing industry, which has been giving its products away for free online for years, that transition might prove trickier. Financial Times chief executive John Ridding has said that newspapers need to abandon a “free is good” doctrine, then work out what sets them apart from competitors and how they can charge for it, while Rupert Murdoch has taken the bold step of asking the News International management team to fix a “fair price” for news throughout his empire by August 2010. With the Times lagging behind the Mail, Guardian and Telegraph sites in the UK and the New York Post only the 27th most important news site in the US, his decision to blink first looks ambitious.

At the start of the month, Murdoch gave an intriguing first glimpse of how his new revenue streams might look. Times+, a paid membership scheme, provides members with access to special events, offers and meetings with its journalists for £50 a year. Katie Vanneck-Smith, managing director of News International’s Customer Direct division, said the Times titles were moving away from the strategy of bringing in as many readers as possible in favour of “developing more direct relationships with our customers based on their interests and passions”.

The old ‘unique user’ model may well be fading but users will want to hang on to the free ride for as long as possible, and big companies have rarely been well placed to lead the kind of innovation that trumps a threat of this magnitude. Yet the desire to find a smaller audience willing to pay for access to a quality brand’s niche product or premium delivery echoes many of the principles of the freemium model. Has Murdoch outdone the entrepreneurs at their own game? Mork is unconvinced. “It’s one thing to make visionary statements and say you’re going to change the business model,” says Mork. “What consumers are willing to pay is quite another.”